Reporting Research and Development Costs

Question: Many companies create internally developed intangibles such as copyrights and trademarks. One common intangible of this type is a patent, the right to make use of an invention. The creation and nurturing of an idea so that it can eventually earn a patent and be offerred for sale often takes years. The monetary amounts spent in this way to arrive at new marketable products are often enormous. The risk of failure is always present.

Such expenditures are essential to the future success of a great many companies. In 2010 alone, Intel reported spending $6.6 billion on researchThe attempt to find new knowledge with the hope that the results will eventually be useful in creating new products or services or significant improvements in existing products or services; these costs are expensed as incurred according to U.S. GAAP. and developmentThe translation of new knowledge into actual products or services or into significant improvements in existing products or services; these costs are expensed as incurred according to U.S. GAAP. in hopes of discovering new products to patent and sell. During the same one-year period, Bristol-Myers Squibb incurred costs of $3.6 billion on research and development. Those are clearly not inconsequential amounts. What is meant by the term “research”? What is meant by the term “development”? If a company such as Intel or Bristol-Myers Squibb spends billions on research and development each year, what accounting is appropriate? Should an asset or expense be recognized or possibly some combination? The outcome is uncertain, but the money was spent under the assumption that future economic benefits would be derived.

For example, assume that a technological company or a pharmaceutical company spends $1 million in Year One to do research on Future Product A. The company then spends another $1 million during the same period on development costs for Future Product A. At the end of this year, officials believe that a patent is 80 percent likely for Future Product A. If the patent is received, sales can be made.

Also during that time, the company spends another $1 million in research and $1 million in development in connection with Future Product B. However, at year’s end, the same officials are less optimistic about these results. They believe that only a 30 percent chance exists that this second product will ever receive a patent so that it can be used to generate revenues. According to U.S. GAAP, what reporting is appropriate for the cost of these two projects?

Answer: Definitions are easy to recite.

• Research is any attempt made to find new knowledge with the hope that those results will eventually be useful in creating new products or services or significant improvements in existing products or services.
• Development is the natural next step. It is the translation of that new knowledge into actual products or services or into significant improvements in existing products or services.

In simple terms, research is the effort expended to create new ideas; development is the process of turning those new ideas into saleable products.

However, the reporting of research and development costs poses incredibly difficult challenges for the accountant. As can be seen with Intel and Bristol-Myers Squibb, the quantity of these expenditures is often massive because of the essential role that new ideas and products play in the future success of many organizations. Unfortunately, significant uncertainty is inherent in virtually all such endeavors. The probability that any research and development cost will eventually lead to a successful product can be impossible to determine for years. Furthermore, any estimation of the outcome of such work is open to manipulation. Often the only piece of information that is known with certainty is the amount that has been spent.

Thus, except for some relatively minor exceptions, all research and development costs are expensed as incurred according to U.S. GAAP. The probability for success is not viewed as relevant to this reporting. Standardization is very apparent. All companies provide the same information in the same manner. The total cost incurred each period for research and development appears on the income statement as an expense regardless of the chance for success.

Consequently, the accounting for Future Product A and Future Product B is identical. Although one is 80 percent likely to be successful whereas the other is only 30 percent likely, all research and development costs for both are expensed as incurred. No asset is reported despite the possibility of future benefits. The rigidity of this rule comes from the inherent uncertainty as to whether revenues will ever be generated and, if so, for how long. Rather than trying to anticipate success, the conservatism found in financial accounting simply expenses all such costs as incurred. The percentages associated with the likelihood of receiving a patent and generating future revenues are ignored.

Two major advantages are provided by this approach. First, the amount spent by a company on research and development each period is easy to determine and then compare with previous years and with other similar businesses. Most decision makers are interested in the amount invested in the search for new ideas and products and that information is readily apparent. Second, the possibility for manipulation is virtually eliminated. No distinction is drawn between a likely success and a probable failure. No reporting advantage is achieved by maneuvering the estimation of a profitable outcome.

Research and Development Costs and the Impact on the Balance Sheet

Question: Billions of dollars are spent each year on research and development in hopes of creating new products that could be sold in the future. Company officials would never risk this money unless they believed that a reasonable chance existed for recouping such huge investments. However, whether success is 100 percent likely or only 2 percent, no assets are reported on the balance sheet for these costs. That is U.S. GAAP.

Because all amounts spent on research and development are expensed automatically, are the assets reported by companies in industries such as technology and pharmaceuticals not omitting many of their most valuable future benefits? If a company spends $5 billion to develop a new drug or electronic device that becomes worth $11 billion, does the reporting of no asset make sense? Does that approach provide a fair portrait of the company?

Answer: Even a student in an introductory accounting course can quickly recognize the problems created by a rule requiring that all research and development costs be expensed as incurred. Companies in technology, pharmaceutical, and many other industries must exclude items of significant value from their balance sheets by following U.S. GAAP. While this approach is conservative, consistent, and allows for comparability, the rationale is confusing. The balance sheet hardly paints a fair portrait of the assets being held. Expensing research and development costs also violates the matching principle. These expenditures are made in the hopes of generating future revenues but the expense is recorded immediately before any revenues have been earned.

Capitalizing these costs so that they are reported as assets is logical but measuring the value of future benefits is extremely challenging. Without authoritative guidance, the extreme uncertainty of such projects would leave the accountant in a precarious position. The temptation would be to tailor the reporting to make the company look as good as possible. U.S. GAAP “solves” the problem by eliminating the need for any judgment by the accountant. All costs are expensed. No rule could be simpler to apply.

Consequently, any decision maker evaluating a company that invests heavily in research and development needs to recognize that the assets appearing on the balance sheet are incomplete. Such companies spend money to create future benefits that are not being reported. The wisdom of that approach has long been debated but it is the rule under U.S. GAAP. Difficult estimates are not needed and the possibility of manipulation is avoided.